There is no contradiction between using book value for
purposes of estimating capital invested and using market
valueforestimatingcostofcapital,sinceafirmhastoearn
morethanitsmarketvaluecostofcapitaltogeneratevalue.
From a practical standpoint, using thebook value cost of
capitalwilltendtounderstatecostofcapitalformostfirms
andwillunderstateitmoreformorehighlyleveredfirmsthan
forlightlyleveredfirms.Understatingthecostofcapitalwill
lead to overstating the economic value added.
EconomicValueAdded,NetPresentValue,andDiscounted
Cash Flow Valuation
Oneofthefoundationsofinvestmentanalysisintraditional
corporatefinanceisthenetpresentvalue(NPV)rule.Thenet
presentvalueofaproject,whichreflectsthepresentvalueof
expected cash flows on a project, netted against any
investmentneeds,isameasureofsurplusvaluecreatedbythe
project.Thus,investinginprojectswithpositivenetpresent
valuewillincreasethevalueofthefirm,whereasinvestingin
projects withnegative netpresentvalue willreduce value.
Economicvalueaddedisasimpleextensionofthenetpresent
valuerule.Thenetpresentvalueoftheprojectisthepresent
valueoftheeconomicvalueaddedbythatproject overits
life.
11
whereEVAtistheeconomicvalueaddedbytheprojectin
yeartand the project has a life ofnyears.